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Expenses that must be paid no matter how many goods or services are offered for sale are
called fixed costs. There are other types of costs that change with the number of products offered
for sale. These are called variable costs.
In order to conduct the cost volume profit analysis, it is very important to understand the
difference between fixed and variable costs. We identified FARR Ceramics Ltd.’s fixed and
variable costs to have a better understanding about the company. The fixed and variable costs are
listed below:
At any and all levels of output, the fixed costs of FARR Ceramics’ Ltd. will always remain
the same. The following table shows the percentage of total fixed cost used to cover the
individual fixed cost components for the year 2016.
Fixed costs are cost that do not change in total with the change in the quantity of output
produced by a firm within relevant range in the short run. They remain constant even when your
revenues rise or fall. Total fixed cost is one part of total cost. Fixed costs are permanent and have
to be incurred independent of the quality of goods and services produced.
As FARR Ceramics is a manufacturing company, 0ut of the total variable cost it spends most
of the money to cover those variable costs which falls under direct material and manufacturing
overhead. The following table shows the percentage of total variable cost used to cover the
individual variable components of the year 2016.
A variable cost is a cost that changes in total with the change in volume but per unit cost
remains fixed. Unlike a fixed cost, variable cost changes with the units change. This cost rises as
the production output level rises and decreases as the production output level decreases. The total
fixed costs of FARR Ceramics since 2012 to 2016 are shown below:
Figure 4 shows that during the recent years the total variable costs of FARR Ceramics Limited
haven’t experienced much fluctuation except the year 2015. The variable cost of 2013 was
slightly higher because the costs of wages, depreciation, power and packing materials increased a
bit compared to the other years.
In 2015 there was a huge downfall in total variable cost due to change in variable cost per
unit. The material cost per unit, variable labour cost, packing and power cost may go down in
that year.
Contribution Margin
Contribution is the difference between sales and variable costs (expenses). Contribution
represents the portion of sales revenue that is not consumed by variable costs and so contributes
to the coverage of fixed costs. It represents the amount of income or profit the company made
before deducting its fixed costs.
2012 729570282
2013 665384355
2014 723272159
2015 676132218
2016 475001327
The figure shows that there was not much difference between the contribution margins of
2012 to 2015. But In 2016 an increase in variable costs caused the contribution margin to shrink.
Contribution ratio is the contribution margin divided by the sales amount. It is the percent of
sales amount available to cover fixed costs. Once fixed costs are covered, the next amount of
sales results in a company's profits.
Table 7 shows the contribution margin ratio, which is the percentage of each sales taka that is
available to cover fixed costs and provide income.
In the Figure 6 we can see that the contribution ratios from 2012 to 2015 were almost same. It
shows that the contribution ratio was always moving between the ranges of 35 percent to 40
percent. That means theses portions of sales revenue were not consumed by variable costs and
contributed to the coverage of fixed costs. The ratio was highest in 2015 compared to the other
years because the variable cost per unit decreased significantly. But the contribution ratio of
2016 was much lower than the previous years, this happened due to an increase in variable costs
and decrease in sales revenue. That means a large portion of the sales revenue was consumed by
variable costs and caused a decrease in contribution ratio.
The break‐even point represents the level of sales where net income equals zero. In other
words, the point where sales revenue equals total variable costs plus total fixed costs, and
contribution margin equals fixed costs.
Table 8 shows FARRs breakeven point of five years when their sales reached a volume at
which producing products became profitable. At the break-even point, the company recovered its
investments in production and began turning a profit with each additional sale.
The Figure 7 shows that the breakeven points were almost moving at the same level since
2012 to 2015.The BEP was lowest in 2012, this happened due to lower fixed cost and higher
contribution margin. In 2016 the breakeven point went sharply upward. One reason was an
increase in the company's fixed costs. A second reason for the increase in FARR Ceramic’s
break-even point was a reduction in the contribution margin, as a result of a greater proportion of
lower contribution margin products were sold. Due to these reasons the breakeven point of 2016
was highest among the other years.
Margin of safety is used in break-even analysis to indicate the amount of sales that are above
the break-even point. The Table represents the marginal safety of the FARR ceramics.
Margin of Safety is the amount of sales which generates profit. In other words, sales beyond
Break Even Point are known as Margin of Safety. It is calculated as the difference between total
sales and the break-even sales.
The figure represents the marginal safety of FARR ceramics since 2012 to 2016. The size of
margin of safety is an extremely important guide to the financial strength of a business. From
2012 to 2014 the marginal safety was large enough, which indicates that during those years BEP
was much below the actual sales, that means business was in a sound condition and reduction in
sales would not have affected the profit of the business. After 2014 the margin of safety of the
company started to decrease. The margin was lowest in 2016 this happened due to an increase in
the breakeven point and any decrease in sales volume could have cause a loss to the company.
Net income refers to net earnings calculated as sales less cost of goods sold, admin expenses,
selling and marketing expenses, operating expenses, depreciation, interest and taxes. The
following table represents the net income of FARR Ceramics from the year 2012 to 2016.
The break-even analysis helps in finding out the relationship of costs and revenues to output.
It enables the financial manager to study the general effect of the level of output upon income
and expenses and, therefore, upon profits. This analysis is usually presented on a break-even
chart. It helps in understanding the behaviour of profits in relation to output. Such an
understanding, among other things, is significant in planning the financial structure of a
company. To understand the profitability nature of FARR Ceramics Limited we have created
break-even chart for the years of 2012 and 2016.
In these break-even charts, the concepts like total fixed cost, total variable cost, and the total
cost and total revenue are shown separately. It will also give an idea about the extent of profit or
loss to the firm at different levels of activity.
The figures below shown are the graphical representation of the break-even analysis of 2012
and 2016 in the forms of a chart. The sales units are shown on the horizontal axis and costs and
revenue on vertical axis.
Here we can see that the fixed costs stayed the same regardless of how many units the
company sold during those years. From the fixed costs lines show that the fixed cost of
2016 was much higher than 2012. The Variable costs are dependent on production output.
From these charts, we can see that the variable cost line of both the years were almost at the
same. The total expenses lines show that they have a positive or upward slop that indicate
the effect of increasing variable expenses with the increase in sales units. Total cost amount
of 2016 was higher compared to the year 2012. The total revenue lines and the total
expenses lines crossed each other. The point at which they crossed each other is the break-
even point of 2012 and 2016. Notice that the total expenses line is above the total revenue
line before the point of intersection and below after the point of intersection. It tells us that
the business suffers a loss before the point of intersection and makes a profit after this point.
The break-even point in the above graphs are 23,52,23453 for 2012 and 61,66,66697 that
agrees with the break-even point computed using equation and contribution margin methods
above.
Now if we compare the charts of 2012 and 2016, it can be seen that the difference
between the total expenses lines and the total revenue lines before the point of intersection
(BE point) is the loss area. This area reduces as the number of units sold increases. It means
every additional unit sold before the break-even point reduces the loss. The loss area of the
company started to increase after 2012. This happened due to a decrease in sales revenue
after the year 2012 in a continuous manner. Again, the difference between the total expenses
line and the total revenue line after the point of intersection (BE point) is the profit area.
Notice that this area increases as the number of units sold increases. It means every
additional unit sold after the break-even point increases the profit of the business. It can be
seen that the profit area decreased in a significant manner in 2016. This happened due to
higher fixed cost and lower contribution margin.
Production capacity
The production details of FARR Ceramics in the years 2012 to 2016 is given. They
produce three categories of finished products which are A, B and C. A Categories are
completely export oriented, B categories are also export oriented but sometimes released in
local market whereas C categories are only for the local market.
Category A
Category B CategoryC Total
(In Units) (In Units) (In Units)
(In Units)
2012 2776547 345567 2446787 5568901
2013 3000089 455000 2334576 5789665
From the above table, we can see that the expansion in 2016 has had a positive impact on
the number of units being produced, which was a constraint that was being faced by the
company till 2015 to meet market demand.